Unqualified Opinions 5/1/23 - 5/5/23
By Tim Hanson
The Culture Beast (5/1/23)
Where you work, who’s responsible for culture?
The most common answers we hear to this question are “Nobody” or “Everybody,” which is to say that no one is specifically accountable for sustaining one of the most valuable assets at any organization. Don’t think that’s true? Public companies with satisfied employees have been shown to outperform their peers and, for our own part, we’re much more excited to invest in (and will pay a higher price for) companies that have great culture. Why? They’re more likely to attract and retain top talent, which is probably the biggest challenge facing small businesses.
But those answers also make sense because one person can’t force culture on others. Culture is something that has to be built and shared across teams.
That’s also problematic, though, because it makes culture a fickle beast. We all know empirically that as businesses grow their cultures tend to get diluted. I’d never heard an elegant explanation for this phenomenon until I was recently sent a copy of the research paper “Corporate Culture and Organizational Fragility.”
The authors sum the problem up neatly:
Because a strong corporate culture relies on costly, voluntary investments by many workers, we model it as an organizational public good, subject to standard free-riding problems, which become severe in large organizations…workers’ incentives to make voluntary contributions to any genuinely corporate (as opposed to more local) culture vanish as an organization becomes large, because their marginal impact becomes negligible while their marginal cost does not.
So how can you grow a business without sacrificing culture? The specific tactics are likely to be unique to your organization, but using some fancy math the authors of that paper make two general recommendations. First, make lots of small, decentralized investments in culture. Second, promote from within.
Those make sense to me and I’ll add two more: (1) Measure it; (2) Don’t take it for granted.
There Is No Medium Effort
(5/2/23)
One thing that I believe to be true about finance is that there is no medium risk. This is the idea that if you take any investment risk at all, what you are risking capital on can always go to zero, so you should either keep your money in safe assets or seek high returns that compensate you for taking risk. It’s anathema to the way a lot of asset pricing is structured, but I believe it to be true and conduct ourselves accordingly. For example, if you looked at Permanent Equity’s balance sheet you would see cash and illiquid long-dated investments.
I also spend a lot of time thinking about where else this barbell approach might apply.
That topic came up the other day when I was talking to someone who expressed frustration about certain tasks, like writing update emails, taking too long and therefore causing him to shortchange other meaningful tasks where he thought he should be spending more time. After talking it through we landed on a challenge: that he no longer spends 45 minutes on anything. Rather, he should divide his priorities into items that should take 5 minutes or less and others on which he wanted to spend a half day or more. In other words, there is no medium effort. Either do it fast or do it.
A seminal book that I read early in my career was Getting Things Done by David Allen. It’s full of lots of tips and tricks, but one that I’ve abided by ever since I read it is that if something comes across your desk that you can do in 5 minutes or less, do it right then and there. That approach has been a life-changer for me and is the reason why if you send me a short email, you’re likely to get a response in 5 minutes or less (please don’t all try that at once).
But as I was thinking about the challenge I talked through with my colleague, I wondered if it applied to me as well, but in the other direction. I, too, take 45 minutes to do a lot of things, but maybe these are things I should be spending more time on. Even if something seems settled, if it’s important enough, is it worth revisiting a few times over?
Suffice to say, I’m going to try it and see what happens. My productivity may suffer, but maybe that will be worth it if my product levels up.
All Models Are Wrong
(5/3/23)
Based on the number of responses I received, the idea that spreadsheets can be dangerous resonated. One of the more interesting takes came from Kyle, who described himself as having years of experience “on both sides of the spreadsheet argument.” He pointed out that “great people, great ideas, and great markets can overcome the worst spreadsheets.”
That context makes now a good time to point out that no financial model is ever correct. In fact, I’m pretty sure that it’s a law of the universe that once you forecast numbers in a spreadsheet those numbers will never ever come to be. So, to Kyle’s point, you want to make sure you are working with people, ideas, and markets that are likely to make your projections wrong about the upside, not the downside.
One of the first investments I ever made with my own money was buying stock in Whole Foods when I was in college. While I am loath to ever sell anything, I did eventually sell Whole Foods years later when the valuation got pretty crazy in late 2005.
For context, the chain at that time was growing quickly with tailwinds and had approximately $400M of operating cash flow against $4.7B of sales, for a pretty great (for a grocery store) cash flow margin of almost 9%. It was a good company! Investors thought so, too, because they had bid the value of the company up to over $10B, meaning shares could be bought or sold for 25x cash flow.
Now, I don’t know about you, but I invest to try to earn at least double-digit returns annually. For Whole Foods to deliver that on a cash flow basis on that valuation it would have to more than double in size while also maintaining best-in-class margins at the same time that copycats were emerging and competitors were catching up.
Was I able to make a spreadsheet at that time that made a case for Whole Foods doing just that? Of course I could. But as I stared at the numbers, it became clear that if that scenario were to come to pass, Whole Foods would have to sustain economics that no grocery store had ever achieved.
Reasoning through it I thought that might be difficult since Whole Foods was a grocery store.
Twelve years later Amazon acquired that grocery store for $13.7B. Whole Foods at that time had $16B of sales and $1B of operating cash flow. It had grown a lot and done great, but margins had contracted, not expanded (to look more like a grocery store’s) and its valuation multiples had compressed (to look more like a grocery store’s). In other words, holding Whole Foods would not have been a bad decision because it was a good grocery store but if I’d held from the point I sold to the point Amazon bought, I’d have earned about 3% annually. Not great!
This is an example where, to steal from Kyle’s framework, there was a spreadsheet and arguably great people and great ideas, but not a great market. And that’s the factor that ultimately carried the day.
I was talking to one of our operators recently and he pointed out that despite putting a lot of time, energy, and thought into his budget models, his projections had never been close, and we could laugh about that because reality had always been better. As I’ve reflected on why that is, and this is why I am shamelessly appropriating Kyle’s framework, it’s because the people, ideas, and market at that business have proved to create opportunities that didn’t fit in any spreadsheet, which is a fantastic problem to have.
Should AI Run HR?
(5/4/23)
A paper called “Hiring, Algorithms, and Choice” crossed my desk recently, and I found it interesting enough to pass along to Kelie (our Director of Talent Acquisition) and Mark (our COO who also has strong opinions about people). The paper asks very fairly “Why do organizations still conduct job interviews?”
The basis for the question is that people are bad at predicting future performance and fit and that algorithms and AI are better at it and also more efficient. Given that, why aren’t organizations turning over their hiring processes to technology? Now, many have to some degree, and even though we’re not running a business that employs thousands of people or more, even Kelie utilizes automated tools to do screening.
Yet interviews persist. Is there a good reason or is it just theater?
One thing that’s true about Permanent Equity is that we’ve never regretted having dinner with anyone. Even if we show up without an agenda and unsure of our purpose, breaking bread is never without benefit. You build trust, rapport, and loyalty and probably have some fun, which ideally is what happens on both sides of an interview, as Kelie pointed out to me.
To put that in the language of transactions, these experiences generate credits in the relationship bank, credits that are hugely valuable when times get tough and hard decisions have to be made.
The authors of the aforementioned paper reach a similar conclusion about interviews, citing the work of American philosopher T.M. Scanlon. By bringing other employees into the choice of who to hire through the interview process, it validates those employees and also likely makes the hire more successful than it otherwise would be (given equal measurable “fit”) since everyone who was involved in the choice has an interest in seeing their choice validated.
If this is true, then hiring is not an objective process, but rather a cultural one in which the means may be as important as the end. Thinking that through kind of blew my mind and reframed the entire hiring process for me. Maybe there is more to it than filling the role with the most qualified person as quickly as possible.
And if that’s the case then the two rules of culture apply (1) Decentralize it and (2) Promote from within. Or as they may pertain to hiring: (1) Let teams hire their own and (2) Only hire externally for entry level roles.
I might have ended this piece right there, but as Mark pointed out to me, there is more nuance to hiring than that. “If you only hire leadership from inside, your organization’s self-awareness and innovation can stagnate,” he says. “As with most things, it’s a balance.”
He’s right, of course. After all, I wouldn’t be here at Permanent Equity if Brent had only promoted from within.
What’s Your Cost of Capital?
(5/5/23)
Cost of capital is a concept that (1) is near and dear to my heart and (2) gets a bad rap for being abstract when in fact it’s probably the foundation for every disagreement people have with one another. For example, if you and your significant other want to leave at different times to drive somewhere because one of you expects traffic and the other doesn’t and would prefer more time to pack, that's cost of capital.
Don’t believe me? Your time is your capital and your opportunity cost and traffic are your risks, so you are both backing into different fair values of departure times based on different acceptable margins for error. And God help you if you end up being the wrong one...
Or let’s say you bought a lottery ticket with a billion dollar jackpot picking the numbers that are your grandkids’ birthdays because you had a feeling that there was a really good chance you would win. Then let’s say a stranger came up to you and offered to buy your ticket for less than you paid for it, but more than zero. Mathematically, it would be a no-brainer for you to take that offer because lottery tickets have negative expected value. Once you bought one, getting anything more than zero would be a win!
But the reason you bought it is because you had a feeling, and if it’s a billion-dollar jackpot, think about what you might sell that ticket for. $100? $100k? $1M?
This is the reason game shows like Let’s Make a Deal, Who Wants to Be a Millionaire, and Deal or No Deal work. Because there’s tension when counterparties assess odds and values differently. Again, that’s the cost of capital.
See, we’re all fair-valuing everything all of the time and transacting when we think it suits us. This means we mostly try to buy things that we think are undervalued and sell things that we think are overvalued, except when we find ourselves in times of distress, i.e. there’s a need for immediate action. But leaving aside those times when we put ourselves in a pickle, there is an academic definition of this. Cost of capital equals the risk-free rate plus volatility times the return one expects to get for taking risk in excess of no risk.
But here’s how I’d put it in layman's terms…
Your “cost of capital” is what you can do by just getting out of bed plus your probability of doing something great times the magnitude of that greatness.
Knowing that, if you struggle to reach agreements with people, it should prompt consideration of all of those variables…and also of what you decide to do this weekend. Have a great one.
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